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BANK LOANS:

Looking Beyond Interest 
Rate Expectations

WRITTEN BY

CHERYL STOBER
VP, Investment Director

KEY TAKEAWAYS

  • Bank loans are designed to be somewhat resistant to both principal risk
    (because of collateral) and interest rate risk (because of floating coupons).
  • We believe an allocation to bank loans can be a strong addition to a fixed
    income portfolio for both the short-term and long-term investor.

Fixed income investors may be cautious given the current mix of interest rate levels and global macroeconomic news. 


Many investors continue to move between risky assets and relative safe havens like Treasurys based on the latest market headlines.

We believe that bank loans can be a strong addition to fixed income portfolios in this environment and, more importantly, over the long term.

Bank loans have floating-rate coupons, a senior, secured position in the capital structure and an active secondary market—all characteristics that make them compelling investments, in our view. However, bank loans are often perceived as a one-way bet on increasing interest rates or only appropriate as a tactical allocation. In reality, the bank loan asset class can serve a variety of short-term and long-term portfolio functions and deserves deeper exploration.

What are Bank Loans?

When a company seeks capital to invest in its business or simply to finance its ongoing operations, the company may borrow money, raise funds by issuing bonds or stock, or pursue all of these avenues. In fact, many companies that borrow funds through the bank loan market also issue public debt. These are not small companies. Most syndicated bank loans in the US market have principal amounts outstanding between $100 million and $5 billion.

 

Comparison_Fixed_Income_Chart

Source: Morningstar Pitchbook LCD and BofA Merrill Lynch. Data as of 31 December 2022. Please note that the BofA Merrill Lynch US Corporate Index reflects the performance and characteristics of the investment grade corporate credit asset class. See the bottom of the page for index definitions & disclosures.
Past performance is no guarantee of future results.


Bank loan-issuing companies usually have below investment grade (i.e., high yield) credit ratings, and bank loans tend to offer coupon income greater than investment grade bonds but lower than high yield bonds. The greater yield versus investment grade reflects greater perceived credit risk of bank loans, while the slightly lower yield relative to high yield is the result of bank loans’ higher position in the capital structure. For investment grade investors seeking more yield, bank loans provide an intermediate step up in credit risk. The table above compares these asset classes.

As an investment option, bank loans have several key features that can benefit investors, including seniority, security and a floating rate of interest.

SENIORITY

Bank loans, also known as senior loans, are the senior, secured debt at the top of a company’s capital structure; the graphic below illustrates this. Importantly, the holders of a company’s bank loan have a priority claim over the company’s assets in the event
of default.

SECURITY

Bank loans are collateralized, meaning the assets of the borrower secure the loan. Bank loans, even those deemed “covenant-lite,” usually have more covenants in their credit agreement (the equivalent of a bond indenture) than do high yield bonds. Bank loans tend to be issued with seven- to eight-year maturities but are often prepaid early, usually in about three years, in part because these covenants are a burden
to borrowers.

FLOATING RATE OF INTEREST 

Bank loans are also issued with a floating rate of interest, which protects bank loan prices from declining when rates are rising, a marked difference from typical fixed income bonds. Specifically, interest payments on loans are set at a base rate, such as London Interbank Offered Rate (LIBOR) or Secured Overnight Financing Rate (SOFR), plus a spread to reflect credit quality. The base rate plus 1.75%-4.00% has been a common historical average interest rate range.

Corporate_Capital_Structure

The bank loan market is broadly syndicated and consists of loans made by major commercial and investment banks. Bank loans are actively traded in the secondary market like high yield and investment grade bonds, and most major financial firms trade bank loans. As shown below, the bank loan market is similar in size to the high yield market. Bank loans are also generally rated by Moody’s and/or Standard & Poor’s.

 

The bank loan market is broadly syndicated and consists of loans made by major commercial and investment banks.

 

LEVERAGED LOAN & HIGH YIELD INDEX SIZE

Leveraged_Loan_Chart

Source: Bloomberg and Morningstar Pitchbook LCD. Data as of 31 December 2022.

Risks and Other Considerations

Despite their attractive features, bank loans, of course, are not without risks. The principal risks associated with bank loans are credit quality, market liquidity, default risk and price volatility. While bank loans are secured by collateral and considered senior in the capital structure, the issuing companies are often rated below investment grade and may carry higher risk of default.

In addition, the secondary bank loan market, at times of technical pressure, may experience reduced liquidity that may, in turn, adversely affect the prices of these loans. An example of extreme technical pressure was the 2008 global financial crisis, when forced selling from bank balance sheets resulted in steep price declines; a brief history is provided below.

Inefficiencies in pricing and liquidity vary over time in size and frequency but are constants in the market due to investors’ tendency to overreact to corporate events, swings in the supply and demand of government and corporate credit, and perceptions of macroeconomic risk. Furthermore, bank loans, like most high yield bonds, do not trade on an exchange but over the counter. However, unlike high yield bonds, settling over-the-counter bank loan trades is a fairly manual process that can take longer than trades settled through clearing houses. Bid/ask spreads may also be slightly wider on average for bank loans than for high yield bonds, which can result in greater price volatility. However, many bank loans are more liquid than many bonds.

History of Bank Loans

1980s & 1990s
  • Banks reduced their exposure to bank loans by offering their bank loans to non-bank institutions. Mutual funds and insurance companies were early buyers.
  • In the 1990s, more loan funds were started, and pension managers and structured vehicle investors became attracted to the asset class.
2000s
  • Collateralized loan obligations (CLOs) became major buyers of loans. CLO structures were highly leveraged, but buyers were assured by a history of consistent positive annual returns.
  • Hedge funds also were major buyers of loans; they were attracted by loans’ LIBOR-based coupon versus hedge funds’ LIBOR-based funding, and often leveraged their borrowing to help boost prospective returns.
Global Financial Crisis 2007-2009 and the Following Decade
  • Structured mortgage products saw their funding costs spike in 2007, which caused contagion in CLOs. Suddenly, billions of loans could not be converted into structured products because funding costs were too high. Those loans had to be sold in the open market to wary buyers, resulting in deep discounts.
  • In 2008, despite relatively solid performance by the borrowers backing the bank loans, the category’s prices declined on forced selling and deleveraging. This created pricing at a level that implied 100% default rates. 2008 became the first year when bank loan returns were negative since the index’s inception in 1992.
  • Late in 2008 and early in 2009, the selling pressure eased. Investors raised new money to buy what they perceived as
    vastly undervalued credits. Loan prices began a typically rising trend back toward par, generally maintaining that value until mid-2015.
  • In late 2015, energy concerns combined with regulatory fears to create technical pressure in the market, causing the second negative year in bank loan history. However, the underlying fundamentals drove a market rebound in 2016 to make the aggregate return of the two years strongly positive.
  • Toward the end of 2018, the Fed signaled that rates would stop rising, and investors worried that recession was imminent. The following year was characterized by the need for liquidity as managers attempted to de-risk their portfolios.
The 2020 Pandemic and Response 
  • Despite a calm start to 2020, pandemic-related fears hit the loan market in March, causing a technically-driven selloff. However, the loan market rebounded fairly soon thereafter, with the highest-rated loans returning to par pricing levels first.
  • After lower default levels occurred than had been predicted at the pandemic’s start, the loan market saw strong growth and returns in 2021 while some other markets struggled with acceptable limits to their tight spreads and high prices in the face of potential interest rate increases.
  • The loan market benefited from those rate increases in 2022 and beat the returns of many other asset classes as recession concerns persisted.


Examples above are shown for illustrative purposes only and should not be considered recommendations for action by investors. They may not be representative of a fund’s current or future investments and they have not been selected based on performance. Loomis Sayles makes no representation that they have had a positive or negative return during the holding period.

Why Invest in Bank Loans?

Understanding the features and risks of bank loans is key to understanding the tactical (short-term) and strategic (long-term) role of bank loans in a fixed income portfolio. In our opinion, the case for bank loans is strong.

In an environment of global economic uncertainty and rising interest rates, bank loans’ potential to mitigate loss may be suited to the prevailing market conditions. Bank loans are designed to have some resistance to both principal risk (because of collateral) and interest rate risk (because of floating coupons). Since bank loans are senior and secured, they can offer some protection from a decline in enterprise value of the borrowing company, unlike bonds that are lower in the capital structure.

Since bond prices often fall when interest rates rise, this could have significant implications for more traditional bond portfolios as rates normalize. Floating-rate coupons allow bank loan prices to remain fairly steady during periods of rising rates/falling bond prices. Also, when bank loans offer current yields close to other near-rated bonds, this up-rate optionality is, by implication, cheap.

The long-term strategic case for bank loans is driven by the asset class’s behavior over a full credit cycle and its historically low correlation to other asset classes. First, the credit cycle is characterized by market conditions of rising rates or declining corporate credit conditions. Rates tend to rise in an improving economy; corporate credit conditions tend to decline in a deteriorating economy. Because economies tend to rise or fall more than they stay the same, one of the two tactical drivers for bank loans is often in effect. Most other asset categories generally are hurt by rising rates, declining corporate credit, or both. Bank loans directly benefit from rising rates and are somewhat insulated from declining credit by their senior, secured position in the capital structure.

CORRELATIONS OF THE CREDIT SUISSE LEVERAGED LOAN INDEX TO VARIOUS ASSET CLASSES
January 1992 - December 2022

BLOOMBERG US TREASURY INDEX -0.27
ICE BofA US MORTGAGE-BACKED SECURITIES INDEX -0.06
GOLD SPOT COMMODITY INDEX 0.04
BLOOMBERG GLOBAL AGGREGATE INDEX 0.10
ICE BofA US CORPORATE INDEX 0.39
ICE BofA US FIXED-RATE ASSET-BACKED SECURITIES INDEX 0.45
S&P 500® INDEX 0.47
MSCI EAFE INDEX 0.48
DOW JONES US TOTAL STOCK MARKET TOTAL RETURN INDEX 0.50
MSCI WORLD INDEX 0.50
ICE BofA US HIGH YIELD INDEX 0.76

Sources: Credit Suisse, Bloomberg Inc. and Ibbotson Associates. Data as of 31 December 2022. See the end of the page for index definitions & disclosures.

Second, the relatively low correlation of bank loans to other asset classes could provide diversification to fixed income portfolios. The Credit Suisse Leveraged Loan Index has generally posted positive annual returns and has low correlation to fixed income and equity assets. Since its 1992 inception, the index had 28 positive annual return periods and 3 negative annual return periods, compared with 7 negative annual periods for the ICE BofA US High Yield Index and 8 negative annual return periods for the ICE BofA US Corporate Bond Index.

Additionally, low volatility from both interest rate changes and credit pressures suggests that bank loans should have low correlation with other investment categories over long periods. The table above shows that only high yield has exhibited a strong correlation to bank loan returns, a phenomenon significantly increased by the global financial crisis. In summary, the strategic case for holding a long-term bank loan allocation is supported by the asset class’s unique characteristics that adjacent sectors, such as high yield bonds or investment grade corporates, generally lack.

POTENTIAL ALLOCATIONS
THROUGH THE BUSINESS CYCLE

Portfolio_Allocation_Chart

Source: Loomis Sayles. The graphic reflects the opinions and assumptions of the authors only and does not necessarily reflect the views of Loomis, Sayles & Company, L.P. Others may have different views. These views apply under normal market conditions and are subject to change at any time without notice.

The Role of Bank Loans
in a Fixed Income Portfolio

As noted previously, bank loans’ investment profile generally places the asset class between high yield bonds and investment grade bonds, including Treasurys. When investor risk appetite is strong, higher-risk assets (such as high yield bonds) may outperform bank loans. When investors become risk averse, higher-quality assets (such as investment grade bonds and mortgages) may outperform bank loans. Recognizing the relative swings in markets, a flexible approach to building a bank loan portfolio can be advantageous. The ability to add risk through high yield or reduce risk via Treasurys, for example, can help a bank loan portfolio manager benefit from different parts of the business cycle as well as technical pressures. Examples of how portfolio allocations might shift during a typical business cycle are shown in the chart to the left.

While flexibility to adjust allocations at the margin can be important to overall portfolio construction, bank loans are inherently credit assets. Therefore, security-specific fundamental credit research is critical to the investment process and portfolio construction. Successful bank loan investing is mostly about winning by not losing. Bank loan issues should be selected for investment largely based on their creditworthiness, structure and price. The following factors are examples of key credit considerations:

  • Cash flow projections
  • Capital structure
  • Underlying asset values and collateral
  • Market position
  • Management strength
  • Industry developments
  • Political climate
  • Economic forecasts

“Loans” are not a monolithic asset class, any more than “stocks” or “bonds” are. Loan portfolios can be constructed to be conservative or aggressive or anywhere in between. A bank loan portfolio manager generally creates a portfolio from hundreds of issues; therefore, broad and deep research support is key to an effective investment process, in our view.

"Bank loan issues should be selected for investment largely based on their creditworthiness, structure and price."

Bank Loans are Additive to Fixed Income Portfolios

The position of bank loans in the menu of fixed income investment choices is unique; bank loans typically offer a higher yield relative to investment grade bonds and generally a higher capital structure position relative to high yield bonds. Bank loans can be additive to a fixed income portfolio by providing some protection from rising interest rates because of their floating-rate coupon and from credit deterioration because of their senior, secured position in the corporate capital structure. Bank loans may also provide diversification benefits from their low correlation to other assets. While bank loan markets can be subject to technical pressures, they are established and broad. An allocation to bank loans can be a strong addition to a fixed
income portfolio for both the short-term and long-term investor.

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Author

Cheryl Stober

VP, Investment Director

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A version of this report was originally published in September 2012. We have updated the data and content as necessary and otherwise believe the information is current and relevant.

Index Definitions & Disclosures

Bloomberg Global Aggregate Bond Index covers the most liquid portion of the global investment grade fixed-rate bond market, including government, credit and collateralized securities. The liquidity constraint for all securities in the index is $300 million.

Bloomberg US Treasury Index includes public obligations of the US Treasury with a remaining maturity of one year
or more.

ICE Bank of America Merrill Lynch US Corporate Index is a Merrill Lynch generated total return index that includes investment grade corporate bonds with ratings of BBB-/Baa3 and above. This index includes fixed rate coupon bearing instruments but excludes floating rate debt, equipment trust certificates and Title II securities.

ICE Bank of America Merrill Lynch US High Yield Index tracks the performance of US dollar denominated below investment grade corporate debt publicly issued in the US domestic market. Qualifying securities must have a below investment grade rating (based on an average of Moody’s, S&P and Fitch), at least 18 months to final maturity at the time of issuance, at least one year remaining term to final maturity as of the rebalancing date, a fixed coupon schedule and a minimum amount outstanding of $250 million. In addition, qualifying securities must have risk exposure to countries that are members of the FX-G10,Western Europe or territories of the US and Western Europe. The FX-G10 includes all Euro members, the US, Japan, the UK, Canada, Australia, New Zealand, Switzerland, Norway and Sweden. Original issue zero coupon bonds, 144a securities (both with and without registration rights), and pay-in-kind securities (including toggle notes) are included in the index. Callable perpetual securities are included provided they are at least one year from the first call date. Fixed-to-floating rate securities are included provided they are callable within the fixed rate period and are at least one year from the last call prior to the date the bond transitions from a fixed to a floating rate security. Contingent capital securities (“cocos”) are excluded, but capital securities where conversion can be mandated by a regulatory authority, but which have no specified trigger, are included. Other hybrid capital securities, such as those issues that potentially convert into preference shares, those with both cumulative and non-cumulative coupon deferral provisions, and those with alternative coupon satisfaction mechanisms, are also included in the index. Securities issued or marketed primarily to retail investors, equity-linked securities, securities in legal default, hybrid securitized corporates, eurodollar bonds (USD securities not issued in the US domestic market), taxable and tax-exempt US municipal securities and $1000 par preferred and DRD eligible securities are excluded from the index.

ICE Bank of America Merrill Lynch US Fixed-Rate Asset-Backed Securities Index is a total return index tracking the overall performance of US fixed-rate asset-backed securities (ABS) and includes US-dollar-denominated ABS having a fixed coupon, a minimum amount outstanding of $25 million and an investment grade credit rating of BBB or higher.

ICE Bank of America Merrill Lynch US Mortgage-Backed Securities Index is a Merrill Lynch generated total return index that includes the GNMA, FNMA and FHLMC sectors. This index includes fixed rate, coupon bearing instruments and the amount outstanding in each agency/type/coupon subdivision of the mortgage market must be no less than $200 million at the start and at the close of the performance measurement periods. It excludes FHA project notes, CMOs, ¼ coupon pass-throughs, GNMA IIs, GPMs, Mobile Homes, and IOs and POs.

Credit Suisse Leveraged Loan Index is designed to mirror the investable universe of US-dollar-denominated leveraged loans (rated 5Bs or lower or carrying spreads of LIBOR + 125 bps or higher). Tenor must be one year or longer; only funded term loans are included, and loans are removed at upgrade to investment grade, maturity, refinancing or workout.

Dow Jones US Total Stock Market Index measures all US equity securities that have readily available prices.

Gold Spot Commodity Index returns are calculated from month-end closing prices, expressed in US dollars per troy ounce. Total returns are equal to the change in price from month-end to month-end.

MSCI EAFE Index is a free-float weighted equity index. The index was developed with a base value of 100 as of December 31, 1969. The MSCI EAFE region covers DM countries in Europe, Australia, Israel and the Far East.

MSCI World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets.

S&P 500 Index includes 500 leading companies in leading industries of the US economy, capturing 75% coverage of US equities. S&P 500® is a registered service mark of McGraw-Hill Companies, Inc.

Morningstar LSTA US Leveraged Loan Index is an unmanaged index of the institutional leveraged loan market.

Indices are unmanaged and do not incur fees. It is not possible to invest directly in an index.

Additional Disclosures

Diversification does not ensure a profit or guarantee against a loss.

Past performance is no guarantee of, and not necessarily indicative of, future results.

This paper is provided for informational purposes only and should not be construed as investment advice. Opinions or forecasts contained herein reflect the subjective judgments and assumptions of the authors only and do not necessarily reflect the views of Loomis, Sayles & Company, L.P. Investment recommendations may be inconsistent with these opinions. There is no assurance that developments will transpire as forecasted, and actual results will be different. Data and analysis does not represent the actual or expected future performance of any investment product. We believe the information, including that obtained from outside sources, to be correct, but we cannot guarantee its accuracy. The information is subject to change at any time without notice.

Any investment that has the possibility for profits also has the possibility of losses, including the loss of principal.

There is no guarantee that the investment objective will be realized or that the strategy will generate positive or excess return.

LS Loomis | Sayles is a trademark of Loomis, Sayles & Company, L.P. registered in the US Patent and Trademark Office.

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